Real Shocks and the Equilibrium Real Exchange Rate: In the Case of Wage Rigidity

Using a simple exchange rate model, this paper investigates the role of unemployment in determining the ejfects of different shocks on the real exchange rate. The presence of unenioloyment in an economy is shown to significantly alter the relationship between real variables and the real exchange rate. This implies that the generally believed traditional propositions concerning real shocks and the exchange rate might not be valid anymore in the economy with unemployment and thus, that l ignoring the importance of unemployment in estimating the exchange rate model may lead to a mis-specification problem. Through a simple illustration of the Korea case over the period 1980 Q] to 1993 Q4, this result is generally supported. Some policy implications obtained from an empirical study indicate ( I ) that unemployment itself is an important determinant of the real exchange rate of the Korean won and (2) that the presence of unemployment could significantly alter the effects of different shocks on the exchange rate not in sign, but in magnitude. In the presence of unemployment in Korean economy, capital inflow tends to raise the real value of the Korean won, while capital augmentation and a rise in unemployment tend to depreciate the Korean won. Change in government spending would not affect significantly the real value of the won.